Raw Finance

At the outset of this post, I need my reader to forget everything he or she has been told about inflation and deflation.  Rising prices of goods and services is not inflation, and likewise falling prices of goods and services is not deflation.  Arguments among economists rage over the true meanings of these terms, so there is no absolute definition of either term.  I am not pretending that I can resolve those arguments in a few sentences.  Rather, I hope to give my reader a guidepost for understanding and predicting inflation and deflation, and the effect each has on economic growth.

The guidepost I am referring to is money supply.  The money supply is total amount of bills and coins (currency) issued by the Federal Reserve plus amounts held by the public in various deposit accounts in all types of financial institutions.  Basically, it is the total of the purchasing power of the entire country.

Milton Friedman defined inflation loosely as too much money chasing too few goods.  Thus, inflation is the cause of price increases.  When the government prints more money, adding to the money supply, prices of goods and services generally increase to maintain equilibrium in the economy.

To make sense of this, a simple example is helpful.  Let’s say a loaf of bread is $3.  Then, anticipating an economic decline, the government passes a stimulus package, thus giving every person in the country a 5 percent increase in their annual income.  However, by putting more dollars into the money supply, the government has diluted the value of the dollar.  It is now worth 5 percent less.  So, the bread seller would have to increase the price of a loaf of bread by 5 percent, or 15 cents, to $3.15 in order to make as much on a loaf of bread as he or she did before the stimulus package was passed.

The above example is obviously oversimplified, but it highlights a fundamental matter of monetary policy: more money is inflationary.

As my reader can probably guess at this point, deflation is a condition where too little money chases too few goods.  This may occur in a situation where the credit market freezes up, and little or no money is available for borrowing.  When consumers cannot get access to money, they cannot spend.  So let’s go back to our bread maker.  A loaf of bread is $3, but then banks stop lending money because of a credit crisis.  With fewer dollars in the money supply, the value of existing dollars rises.  Thus, assuming the value of the dollar has risen by 5 percent, the breadmaker can lower the price of a loaf of bread by 15 cents to $2.85.  A drop in demand due to consumer’s decreased spending would likely necessitate the lowering of the price in order to sell the same number of loaves of bread as the seller did before the credit crisis.

I emphasize again that these are oversimplified scenarios.  However, this discussion of inflation and deflation sets up an analysis of where we are now, and how we can make some predicitions about the future.  We can use the Consumer Price Index, released by the Bureau of Labor Statistics, to examine whether our predictions are accurate, but the money supply is the key to making predictions.

Thanks to Barry Ritholtz, author of The Big Picture blog, and the Federal Reserve Bank of St. Louis, we have the following information about money supply:

There is an inflationary spike somewhere out there, once we get through this massive deflationary period.

Here is the longer term view:

And M1

Notice how this spike dwarfs 2001 post 9/11

Source:
Monetary Trends
Research Division of the Federal Reserve Bank of St. Louis
November 2008

http://research.stlouisfed.org/publications/mt/20081101/mtpub.pdf

As my reader can plainly see from the charts above, the latest moves by the government have created the conditions for a sizeable inflationary spike.  When that will occur is too difficult to tell.  But I will be watching other indicators, such as the price of copper, for increased economic activity.  For the moment, we are undergoing a period of deflation, caused mostly by the collapse in the housing market, that is likely to continue for at least a couple more months.

One can see the effects of deflation in the drop in prices of commodities like oil and gold.  It can also be seen in the dramatic rise in the value of the dollar.  But with the amount of dollars being pumped into the money supply in order to unfreeze the credit markets, combined with the lowering of interest rates, an inflationary spike down the road is almost inevitable.  And such an event can be very damaging to an economy struggling to emerge from a deep recession.  Consider for a moment that during the last recession from 2001 to 2003, the Fed was so focused on reducing (or eliminating) recessions altogether that it encouraged loose lending standards and drastically lowered interest rates in order to spur economic activity, which ultimately led to the housing bubble.  The problem though was not the action the government took to end the recession, but the fact that it left its loose monetary policy in place for too long and then abruptly embarked on a course of tightening credit, thus trapping many consumers in mortgage loans they could not afford and could no longer refinance.  Please note that I am not blaming the Fed entirely for the housing collapse and subsequent credit crisis, but rather, that it’s reluctance to reverse its policies enabled the reckless lending that ensued.

I will continue to monitor the money supply and additional government intervention in the credit markets to keep you updated on the inflationary/deflationary pressures on the economy.  Also, in my next post, I will examine some alternative investments to holding the common stock of individual companies in light of deflation and inflation.